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Sole Trader vs. Limited Company:Key Tax & Legal Differences

Tax savings on incorporation

It may be possible to save tax by running a business through a company. It depends on the combination of many variables.

At the most basic level a sole trader will, if they are profitable pay both Class 2 and Class 4 National Insurance contributions (NICs). If profits are high enough a sole trader will pay tax at higher rates.

A company is not subject to NICs or higher rate tax. A company owner will not be subject to NICs if company profits are extracted out via dividend, and dividends are taxed at a lower rate compared to earnings and so in a straightforward case there may be some tax saving by extracting profits by dividends.

When there are taxable benefits involved the situation may reverse itself. A sole trader may claim tax relief on the cost of running motor car if used for business; a company owner will be taxed on a car benefit charge if he has the use of a company car.

This guide examines the main differences between a business run by a sole trader or as a partnership and a company, managed by its director/shareholder. This comparison is for a trading business. Many of the points summarised here are not relevant if you want to compare individuals or companies managing investment businesses.

Sole Trader or Partnership

You are the business

You are the owner

You are the manager or proprietor

Employment status:

You are self-employed; you cannot be your own employee.

From April 2014 the members of a Limited Liability Partnership who are on fixed profit/no risk arrangements may be automatically classed as employees under proposed anti-avoidance provisions.

Tax on profits:

You pay Class 2 & 4 National Insurance and Income Tax on the taxable profits of your business, or your share of profits, if you are in partnership.

Losses:

You can offset your trading losses against your other income.

From 2013/14 there is a cap on the amount of relief that you may claim for losses and interest payments.

Extracting profits:

You may withdraw cash from the business without tax effect.

Borrowing:

You are free to borrow from the business bank account, it is your account.

If your business bank runs at an overdraft due to the amount of funds that you have withdrawn personally, tax relief on bank charges and interest will be proportionately restricted.

Pension:

You can only have a Personal Pension.

Insolvency:

If the business fails you will be personally (or jointly with your partners) liable for its debts. You may go bankrupt.

Accounts:

There is no requirement that you prepare accounts for tax purposes. However you may find that it is difficult to keep on top of your business, collect debts and work out profits without keeping accounts.

From 2013/14 you have the option of cash accounting or conventional accounting, see Accounting: Simpler Income tax (cash basis) / fixed expenses.

If you trade through a limited liability partnership you must prepare accounts for filing with Companies House., conventional partnerships and sole traders have no such filing requirement.

You may need annual accounts to complete your personal tax return which includes a balance sheet section.

Small businesses may use a very basic (three line) format for a business which trades below the VAT threshold..

Your accounts are not submitted to HMRC unless you are subject to an investigation.

Your taxable profit under Self Assessment must be prepared in accordance with Generally Accepted Accounting Practices (GAAP) for tax purposes unless you are cach accounting.

Selling the business:

When the business or assets used in it are sold, you are personally taxed on any gain under the Capital Gains Tax (CGT) rules.

When the business or assets used in it are sold, you are personally taxed on any gain under the Capital Gains Tax (CGT) rules.

Death:

When you die your business ceases. You can pass all or part of it down to the next generation.

In a partnership you can pass on your share of the partnership.

Business Property Relief (BPR) will apply for inheritance tax (IHT) purposes if the business is a qualifying trade.

Paying yourself:

You can withdraw any amount of profits, but it is not classed as remuneration as you are not an employee.

Paying a salary to a spouse or family members must be commercially justified to be allowable for tax purposes.

Expenses in general:

You obtain tax relief for expenses that are incurred wholly and exclusively for the purposes of the trade.

If you can identify a proportion of an expense that relates to business you can claim the same proportion against tax.

An adjustment must be made for tax to add back the proportion of any expense that relates to “private use”.

Most commonly private use will be in respect of your use of telephone or power, own consumption of goods, and motor running expenses. See What expenses can I claim? (self-employed).

Cars and fuel:

A sole trader or partner can claim capital allowances on a car, disallowing a proportion for private use. See Capital Allowances: vehicles (self-employed).

Low-emission cars can be tax efficient for family members on the payroll.

There is no adjustment for fuel benefit for you as a sole trader, you merely disallow a proportion of your fuel costs in relation to private use. See Motor expenses (self-employed).

Mobile phones:

Mobile phones will be subject to private use so a tax add-back is expected on your tax return.

Computers:

You can obtain capital allowances on a computer. An add back of allowances will apply if there is substantial private use.

Tax-free benefits and incentives:

These do not apply to the self-employed.

Working from home:

You will be able to claim a deduction for mortgage interest, rates and light and heat, if you have an office at home.

Charging rent for use of home:

A sole trader cannot charge himself rent.

Limited Company: you are director & shareholder

The business is a separate legal entity

You are a shareholder; you hold all or a proportion of the company’s share capital

You serve the company as its officer as a director (a company secretary is an officer too)

Employment status:

A director is an office holder, this does not automatically make him an employee in terms of employment law, the National Minimum Wage or for Tax Credits.

For Income Tax and National Insurance purposes company officers are treated as employees.

Tax on profits:

The company pays corporation tax on its taxable profits. Company tax rates are lower than higher rates of Income Tax.

Employees and office holders are subject to PAYE and NICS on their earnings from employment and many benefits attract income tax too.

Shareholders who are higher rate taxpayers will pay additional tax on dividend income.

When IR35 and the Managed Service Company provisions apply, the company must deduct PAYE and NICs on its income.

Losses:

The company can offset its trading losses against its other income, but not against your income as an individual.

Shareholders who are higher rate taxpayers will pay additional tax on dividend income.

When IR35 and the Managed Service Company provisions apply, the company must deduct PAYE and NICs on its income.

Extracting profits. You are taxed on:

Any income withdrawn from the company. If it is a distribution it is taxed as a dividend. If it is earnings it is under PAYE and subject to NICs.

Most employment benefits received by you or your family and household are taxable.

Shares or securities in the company which are given to you at less then market value.

Borrowing:

A director may borrow from his own company. Limits are set by Companies Act 2006, but there are tax costs.

The company will pay a tax charge of 25% if you borrow from the company and do not repay the loan within nine months of the year end.

If the loan is interest-free there will be a tax charge for the director based on beneficial loan interest.

Pension:

Company schemes may be far more generous in terms of benefits and limits than Personal Pension.

You are required to consider pension arrangements for employees.

A SIP or SAS, or an unapproved scheme may be used to hold assets used in the company and may have flexibility on borrowing multiples.

Insolvency:

If the company fails, your liability is limited to the amount unpaid on your shares (if any) unless you have made a personal guarantee (which is often required by banks).

As a director you can be held personally accountable if you continue trading when your company is insolvent and this causes financial loss to creditors. This could result in your personal bankruptcy.

Accounts:

You must prepare annual accounts under the provisions of the Companies Act, these can be abbreviated for filing with Companies House.

HMRC require full accounts for Corporation Tax which must be submitted using its own or specialist software.

Accounts must be prepared in accordance with accounting standards.

From 1 April 2011 most companies must submit their accounts online in iXBRL.

Selling the business:

When the business or the assets used in it are sold, there is a double tax charge on shareholders. The company pays corporation tax on any profit that it makes on disposal. The shareholders are taxed on the distribution of the proceeds.

It may often be more efficient to sell the shares in a company, rather than its trade or business, or individual assets.

Company shares can be gifted.

Providing you own more than 5% of a trading company, a disposal with gains of up to £10 million may qualify for CGT Entrepreneurs’ Relief.

Death:

When you die the company lives on: it is a separate legal entity.

The company’s shares will qualify for Business Property Relief (BPR) for IHT purposes, providing the company is engaged in trade and its activities are not wholly mainly investment activities.

There is no IHT relief on outstanding directors’ loans.

Assets that are held outside the business qualify for 50% BPR.

Paying yourself:

There is no restriction on the size of your salary, but it is subject to PAYE and NICs.

Paying a salary to a spouse or family members must be commercially justified to be allowable for tax purposes.

If your contracts fall within the IR35 regime or the company is a managed service company PAYE and NICs will apply to income.

Expenses in general:

The company obtains tax relief for its expenses if they are incurred wholly and exclusively for the purposes of the trade.

If a director incurs private expenses through the company, they may be treated as earnings, if he is a shareholder the amounts are treated as distributions.

Cars and fuel:

The company obtains full capital allowances on cars, irrespective of any private use by employees. See Capital Allowances: vehicles (companies).

Cars may be expensive as benefits in kind but this depends on list price and the CO2 emissions of the vehicle.

It may be better to run your own car and the company can reimburse using HMRC’s Authorised Mileage rates.

Low-emission cars can be a tax break for family members on the payroll.

It is not tax efficient to provide company car drivers with fuel for private use, employers are permitted to reimburse company car drivers for business mileage but they must use special employer’s advisory rates.

Mobile phones:

Mobile phones can be provided if the contract is in the company’s name, tax free.

Only one per household.

Computers:

Providing you need to use one to perform your role your company can provide a computer without any tax consequences.

Working from home:

You can claim £4 per week without receipts for home expenses.

Alternatively, the company can reimburse you for light and heat, but not mortgage interest or council tax.

Charging rent for use of home:

A director you may set up a licence between you and your company to rent an office (or other space) in your home or outbuildings. This will enable you to recharge a proportion of mortgage interest and council tax.

You will need to declare this as income and prepare rental accounts as for Self Assessment tax purposes.